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Don’t miss the mark with fair valuation and mark-to-market accounting: FAS 157 is effective for most companies’ financial statements issued this year

Starting with their 2008 first-quarter reports, companies were required to implement new disclosure requirements for fair valuation measurements of financial assets.1 In March 2008, the Securities Exchange Commission (SEC) issued a letter clarifying these requirements as companies prepared Management’s Discussion and Analysis (MD&A) for their upcoming Form 10-Qs.2 Some investors have expressed concerns that the new requirements undervalue or overvalue complex securities that have no market, while others believe that companies are not disclosing enough about the fair valuation of complex securities such as asset-backed securities, which do not have a trading market.3 On July 9, 2008, the SEC held a roundtable to discuss the benefits and challenges associated with fair value accounting and auditing standards. While most panelists applauded the new standards, they agreed that auditors needed additional guidance from regulatory agencies to implement this complex new system. Due to its complexity, companies, auditors and counsel will need to keep abreast of updates or guidance from the SEC or other regulatory agencies regarding fair value measurements and disclosures.

The new fair value framework is a result of FAS 157, issued by the Financial Accounting Standards Board (FASB) in 2006.4 FAS 157 implements a standard fair value measurement system with extensive disclosure requirements and is effective for financial statements (including for interim periods) issued for fiscal years after November 15, 2007. FASB delayed application of FAS 157 for nonfinancial assets and liabilities (e.g., goodwill and intangible assets) until after November 15, 2008. However, the delay does not apply to those nonfinancial assets and liabilities that are recognized at fair value in financial statements on at least an annual recurring basis. In a related statement, FAS 159, companies are given the option to report selected financial assets and liabilities at fair value on an instrument-by-instrument basis.5 A company can elect to measure items at fair value at a certain election date, and shall report unrealized gains and losses in earnings on such items at each subsequent reporting date. Effective for the first fiscal year after November 15, 2007, FAS 159’s objective is to allow companies to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.6

Fair Value Defined

FAS 157 was adopted to provide information to investors about how companies measure fair value. In particular, FAS 157 divides the inputs used to measure fair value into a hierarchy of three levels, based on the degree of certainty associated with the valuation of the financial asset or liability, with primacy given to “observable” inputs rather than “unobservable” inputs:

Level 1 inputs are those with observable market prices, such as a stock traded on the New York Stock Exchange.

n Level 2 inputs do not have observable prices but have inputs based on them, such as a bond that is not actively traded but is valued by another bond with similar terms that is actively traded.

Level 3 inputs, which are the least desirable in measuring fair value, are inputs that do not have observable prices, usually assumptions upon which the company bases its internal valuation model.

FAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” It may not be the amount paid to settle a liability but instead must be the amount that would be paid to transfer a liability to a new obligor. Asset values must be determined first by using Level 1 or 2 inputs where available, even if the market is less liquid than in previous periods. A company does not have to consider actual market prices if such prices are a result of a forced liquidation or distress sale. Only if observable prices are not available can a company turn to Level 3 inputs. If a company uses a Level 3 input (for example, a model), it must still take current marking pricing and conditions into account when considering the value they would receive if they exited the position at that time rather than in the future.

Disclosure Requirements

Generally, companies must disclose the following to regulators and investors under FAS 157:

The extent to which they measure assets and liabilities at fair value.

Methods they use to measure fair value and the effect of fair value on their earnings.

For measurements made on a recurring basis, quantitative disclosures about fair value measurements for each major category of assets or liabilities. For Level 3 inputs, a reconciliation of beginning and ending balances (including total gains and losses, realized and unrealized).

For measurements made on a nonrecurring basis, the measurements recorded and the reasons for them. For Level 3 inputs, a description of the inputs and how they were developed.

Most concerning for many companies, FAS 157 requires extensive disclosures concerning Level 3 (unobservable) inputs if the use of these inputs is material. In its Management’s Discussion and Analysis (MD&A), a company should report, along with any other details it finds material:

How inputs were determined and how they affect fair value measurements.

Potential changes that could impact the results (for example, due to liquidity).

The SEC has also listed a number of other items that a company should consider disclosing for assets valued using Level 3 inputs, such as the percentage of total assets measured using Level 3 inputs, reasons for material increases or decreases in Level 3 assets or liabilities resulting from a transfer to Level 1 or 2, and material changes in fair values.

FAS 159 also requires certain disclosures to be made. While it allows companies to use fair value measurements for specified financial instruments on an instrument-by-instrument basis, it requires management to disclose why it elected the fair value option for these instruments. Furthermore, if a company elects the fair value option for some but not all assets in a similar group, it must explain the reason for such partial disclosure.

Discussion and Analysis

Many companies are adjusting to these new regulations and to the numerous disclosures they must now make in their financial statements. One of the principal challenges surrounding FAS 157 relates to Level 3 inputs. While fair value accounting and mark-to-market accounting may seem best left to auditors, companies should not ignore the legal ramifications of their valuation methods and their accounting disclosures. To ensure that an effective valuation system is in place and that disclosures are clearly reported to the public, companies must consult extensively with auditors and with counsel. Securities class actions as well as SEC and DOJ investigations of companies related to their accounting methods highlight the care that all companies, including their management, must take in valuing their assets. In a volatile market, investors may be more likely to scrutinize disclosures for any potential problems and to look for failures to disclose after the fact. Accordingly, compliance with the SEC’s suggested disclosure framework for MD&A is highly advisable.

There will likely be significant variation among companies in the application of the standard to Level 3 inputs and documenting each specific application of the standard is an important component of internal control. In addition, companies should consider whether they have internal personnel with sufficient expertise in the required fair value measurements to implement and continually apply the standard. A lack of required accounting expertise on a particular matter can be a material weakness or significant deficiency, particular for those companies where FAS 157 is material to results of operations. Companies should consider outsourcing key requirements if, after the first quarter of implementation, there is a concern that their internal control report and assessment may be impacted.

Furthermore, lawyers and management should be involved in and understand the fair value measurement process to ensure that a company’s public filings reflect the numerous disclosure requirements of the SEC’s March 2008 letter. To ensure that its valuation system is accurate, management must consult with auditors. To ensure that its disclosures to the public are comprehensive and clear, a company should engage outside counsel with expertise in financial reporting requirements. A lack of compliance with generally accepted accounting principles (GAAP) can expose companies to regulatory investigations and civil lawsuits.

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